Organisational Performance – process and computation

This research explores whether the Shareholder Wealth Creation (SWC) index proposed by Carton & Hofer, (2006) is a suitable performance measurement model. The SWC index by its design categorises the enterprises into high, medium and low performers. As an alternative, this research has also explored if the Shareholder Value Add (SVA) methodology first proposed by Rappaport, (1981,

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1998) is an appropriate model of measurement. The SVA methodology generates a value score that is continuous which has been used when studying the causal relationship between the independent variables namely, EO and ACAP and performance. As explained in section 2.3, the main objective of identifying a proper performance measurement model was however to be able to classify the microenterprises in the sample as high, medium or low performers based on their firm level characteristics. In order to do this the 'Value' score was combined with the Internal Rate of Return (IRR) to devise a template to categorise the enterprises (please refer to table 11 below).

1 Shareholder Wealth Creation (SWC)

As suggested in section 2.3.4, the following equation (Carton and Hofer 2006) was used to discriminate between high, medium and low performing microenterprises. Organisations scoring greater or equal to 1 were classified as high performing, (labelled ‘SWCH’ and coded 3). Microenterprises scoring less than zero were classified as low performing (labelled SWCL and coded 1). All other firms were classified as medium performing, (labelled SWCM and coded 2).

Where

SWC3 = Shareholders Wealth Creation over a three-year period Gr Ast = Growth rate of Total Assets

Cliab/Ast = Change in liabilities to total assets Calt Z = Change in Altman’s Z-Score

RoA = Return on Assets

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Growth rate of total assets

Drucker (1954) included the ability of an organisation to continue to attract capital as a critical performance dimension. It follows that growth in total assets could be considered as a measure of the performance of an organisation.

Change in liabilities to total assets

The liabilities to total assets ratio is calculated by dividing the total liabilities by the total assets for each year’s financial accounts. The change in liabilities to total assets is calculated by looking at the difference between the ratios for each year. Changing Altman’s Z score

Altman’s Z-score first advanced by Prof. Edward I Altman in 1968 is the most commonly used measure of financial likelihood of organisational failure. Typically, there are two versions of the Altman Z score, one for publicly traded companies24 and another for non publicly traded companies. Since the sample used in this research comprises of microenterprises that are essentially non- publicly traded enterprises, it might be more suitable to use the revised standard formula for non-publicly traded firms given below:

(2) Where

X1 = working capital/total assets X2 = retained earnings/total assets

X3 = earnings before interest and taxes/total assets X4 = net worth/total liabilities

In the revised formula, Altman found that firms with the Z score greater than 2.60 were clearly in the non-bankruptcy category, while those firms with the Z score

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Altman Z score ( publicly traded companies) = 1.2x1 +1.4x2+3.3x3 + 0.6x4 + 1.0x5 where x1 = working capital / total assets ; x2 = retained earnings / total assets; x3 = EBIT / Total assets ; x4= market value of equity / book value of liabilities ; x5 = sales / total assets

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less than 1.10 were clearly in the bankrupt category. Firms between these two values were deemed to be in the grey zone. As discussed earlier, while the above two Altman Z scores have been very popular with financial analysts, it has seldom been used by strategic planners to measure performance. Carton & Hofer (2006) are among the few to make this connection. A quick review of the above equation will reveal its applicability for measuring performance. The Z score will either increase or decrease simply by changing any of the numerators or denominators over a period of time. This change in the Z score because of its high explanatory power (adjusted R2 = 0.59) will automatically vary the SWC score. The Altman Z score is thus a powerful tool in measuring performance but generally overlooked by strategists (Calandro, 2007).

Return on assets (ROA)

ROA measures the organisation’s ability to utilise its assets to create profits. It is defined by the formula:

However, the ROA calculations vary considerably between industries because of differing capital intensity, financial structures and accounting policies. Carton & Hofer (2006) quoting Brearly et al (2001), propose adjusting the ROA calculations to eliminate the effect of interest expense and related taxes from the numerator. The adjusted formula is

Three years of data was used in order to ensure that any short-term distortions in the data were smoothed out over a period of time. To calculate the changes in Altman’s Z score, the non-publicly traded and non-listed version of the equation stated earlier was used. In order to calculate the SWC score for each of the

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microenterprises in the sample the following additional information was generated for each firm from the Companies House database25. The company registration number was entered into the database and the last 3 years annual returns were downloaded. The information was then entered into an Excel spreadsheet before being transferred into SPSS or LISREL for subsequent analysis. Appendix 3(a) shows the exact information that was entered to calculate the Shareholder Wealth Creation (SWC3) index. Appendix 3(b) in turn shows the computation of these inputted data in order calculate the 3 year Shareholder Wealth Creation (SWC3) Index. Based on this SWC index the sample microenterprises were categorised as follows

SWC3 index score Code Description

≥ 1.00 3 High performers

≥ 0.00 and < 1.00 2 Medium performers

< 0.00 1 Low Performers

Table 11: Categorisation of microenterprises using SWC3 scores

A note on the accounting practices used in the UK for small firms

The Companies Act 2006 under Part 15 and its 12 different chapters sets the provisions that have to be met by a private limited company in terms of its accounts and reports. Section 381-384 sets the provisions for companies subject to the small companies' regime. Chapter 2 (sections 386-389) sets the obligations of the accounting records that have to be maintained. Microenterprises have a special provision that allow them to provide summary financial statements. Section 427 under Chapter 7 sets the form and contents of the summary financial statement that need to be provided by unquoted companies. The qualifying criteria as per section 382 (3) are as follows:

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1. Turnover Not more than £5.6 million

2. Balance sheet total Not more than £2.8 million 3. Number of employees Not more than 50

It will be noted that the definition for microenterprises used in this research based on the EU classification (please refer to section 2.1.1) are substantially lower than the criteria presented by the Companies Act 2006. Therefore, all of the sample microenterprises used in this research falls within the small firms definition given in this Act. Quite a few have availed of this provision and provided only abbreviated accounts. Fortunately, the information provided satisfies all the requirements to complete the SWC calculations.